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Let’s put an end to embedded compensation

While the groundwork has been laid, investors continue to wait for regulators

There is an ancient Chinese saying that the best time to plant a tree was twenty years ago. The second-best time is today. The Canadian Securities Administrators should have planted the seeds to eliminate embedded compensation years ago; instead they’re still reflecting on it.

The debate over embedded commissions has raged on for more than 30 years. The latest salvo in this dialogue wraps soon with the comment period on the CSA’s Consultation Paper 81-408 entering its final few weeks. Hopefully, this round will finally yield some progress on the file. Until then, lawyers in the investment industry are working feverishly to get their final comments in ahead of the June 9th deadline.

Ever since embedded commissions were introduced in the late 1980s, critics have complained that they skew advice and cause bias. Proponents, meanwhile, insist embedded commissions have democratized investing by bringing financial advice to the masses (albeit by using a clever, but opaque, structure to lure investors like never before).

On some level, but sides are somewhat correct. The larger issue today revolves around the continued utility and appropriateness given the maturation of the industry and new products that are now available.

What’s at stake?

There are sections in the paper that delve into questions of market efficiency, regulatory appropriateness and the mitigation of potential impacts, among other concerns. The stakes are incredibly high. According to the Investment Funds Institute of Canada, Canadians have about $1.39 trillion invested in mutual funds. The majority of these assets are invested in a way that pays an embedded compensation. It should be obvious that if embedded compensation ends, it would represent a sea change in the Canadian investment landscape.

There are some things that I find disheartening about the exercise. To begin, the paper asks that commenters not re-hash previously made arguments, but rather asks them to provide demonstrable facts. Where was the insistence before? The CSA only commissioned research that empirically demonstrated advisor bias recently, with a pair of groundbreaking reports released in 2015. And yet, there was a clear sense that embedded compensation causes advisor bias that came out of the Fair Dealing Model final report issued by the Ontario Securities Commission in the mid-2000s.

If the CSA honestly wanted evidence of advisor bias, why did it take a decade to commission research to determine whether or not embedded compensation caused bias? Dithering is not a course of action that can be reputably followed by anyone who purports to take purposeful action.

Evidence of bias

If your house was burning, how long would you wait before you called the fire department? Why should we believe the CSA’s claim to want to make policy based on evidence when it took a decade to collect in order to proceed? Spoiler alert: the evidence they collected showed that embedded compensation causes advisor bias.

The prevailing view is that eventually embedded compensation will indeed be abolished in Canada—just as it has been in much of the rest of the developed world. The litany of unsubstantiated arguments made by the defenders of the status quo is finally being rejected.

There is no reliable evidence that eliminating embedded compensation causes an “advice gap” where smaller clients (say those with less than $150,000 of assets) can’t get an advisor. Meanwhile, there is considerable evidence that total investor cost will actually decrease due to advisors being more inclined to recommend more cost-effective products. All told, change certainly seems to be in the air.

The real questions that people will need to turn their attention to now are more operational in nature:

How should we go about doing this?

How much lead time should there be?

What steps can be taken to mitigate the so-called “unintended consequences” of change?

What needs to happen to ensure that the transition is fair, transparent and honourable to all parties?

Regulators will begin to sift through the small mountain of input in earnest once the June 9 deadline passes. It will take many months to digest the information and to come up with a way forward.

Slow progress

Realistically, the absolute earliest that final recommendations regarding how to proceed might be revealed would be very late 2017 (although sometime in 2018 might be more realistic). Then comes the transition phase (prescribing a way forward and implementing it are very different things).

My bet is that embedded compensation will not be eliminated in Canada until 2020 at the very earliest. But at least the seeds are being planted to make that happen.

John J. De Goey is a portfolio manager with Industrial Alliance Securities Inc. (IAS) and the author of The Professional Financial Advisor IV. The views expressed are not necessarily shared by iAS. Industrial Alliance Securities Inc. is a member of the Canadian Investor Protection Fund.

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